Is Wall Street Hustling Facebook?

Let me propose something that not many people are saying Friday morning:

Facebook’s initial public offering price may be too low. Mark Zuckerberg may have been hustled by Wall Street—like so many other tech company founders.

On May 3, Facebook said in a public filing that it would seek an initial price range for its shares between $28 and $35, which would value the social network at that range at between $77 billion and $96 billion. Since only a fraction of the company is being put up for auction, however, the company will only garner a maximum of $13.6 billion if the shares sell at that price range.

Skeptics are pointing out that in many respects a nearly $100 billion valuation is incredible.

Facebook received first-quarter revenues in 2012 of $1.058 billion, which means it is being valued at between 18.1 and 22.7 times annualized first quarter revenues. Facebook's first quarter profits were $205 million, which gives it a valuation of between 94 and 117 times annualized first quarter profits. If we used the full year’s revenue for 2011 ($3 billion) and profits ($1 billion), we’d get a price of 25.7 to 32 times revenue and 77 to 96 times profits.

Those are eye-popping numbers. From now until the initial public offering, you can expect to read lots of bearish arguments against the price. Watch for the words “bubbly,” “stratospheric,” and “inflated.”

You’ll be warned to dodge the hype and avoid the IPO.

This is good advice. Facebook’s IPO, like most IPOs, will be a highly speculative venture. This isn’t appropriate for someone seeking long-term, stable growth to build a nest-egg for later in life.

So how can I wonder if Facebook’s IPO price might be too low? Well, in the first place, the P/E ratio isn’t quite as unbelievable as it may seem. Google was valued at $24.6 billion in its IPO, at a time when its revenues were $1.47 billion and its profits were $106 million.

That tells us that Google was priced at 16.3 times revenue and a truly astounding 232 times profits.

Ultimately, investors care about profits. Facebook’s P/E ratio is far more attractive than Google’s was. The company makes more profit per dollar of revenue than Google was able to—which is very promising for a still-growing company. This means that the company should be able to deliver profit growth on smaller revenue gains than Google could promise when it went public.

The IPO pricing is also below what Facebook was commanding on the private markets. In late March, Facebook shares traded at $44.10 on a private exchange, for an implied valuation of around $102.8 billion (assuming that there were 2.33 billion outstanding shares outstanding).

We all know that there are several recent horror stories in the tech IPO market. Back in December of 2011, Zynga set its IPO price at $10 and fell 5 percent to $9.50 on its first day of trading. It didn’t trade above its IPO price until late January. It was pretty buoyant in February and March but cracked in mid-April, falling back below $10 on April 19.

Groupon shares did well on their first day: IPOing at $20 and hitting the closing bell at $26.11 (a 31 percent gain). Shares traded at a highwater mark of $31.14 afterwards. Recently, however, the price has fallen all the way down to $10.31 per share as of Thursday’s close, a 41 percent decline from the IPO price.

Pandora’s similar: IPOing at $16; hitting $17.42 on the first day’s close; rising all the way up to $26; closing Thursday at $8.82, for a 46 percent decline since the IPO.

But there are several bright spots. Yelp started trading on March 2, 2012. It had an IPO price of $15 per share and closed on its first day at $24.58, a whopping 64 percent gain. The price has come down but it was still up 38 percent over the IPO price as of Thursday’s closing bell.

You can see similar story with Jive, which had an IPO price of $12 and rose 25 percent on its first day of trading. It closed yesterday at $23.05, a 92 percent gain from the IPO.

LinkedIn priced at $45 per share and closed its opening day at $94.25, a better than 100 percent gain. It’s still sitting up there at $109.41, more than double the IPO.

There’s something of a pattern here. With the exception of Zynga, these tech IPO stocks have done very well after the IPO. In fact, you could say some did too well.

LinkedIn, Yelp, Groupon and Pandora all relied on their Wall Street investment bankers to determine a fair market price for their shares—and I believe they all got hustled.

Everyone expects a stock to rise after an IPO because Wall Street under-prices shares as a reward to favored clients (who are themselves “favored” because they pay lots of fees for other services to the investment banks). An IPO price is typically a combination of anticipated market demand for shares minus the Wall Street “vig”—a self-serving agency cost or hidden fee extracted by the banks.

Something between a 10 percent and a 15 percent jump would be a typical vig—or pop on the opening. When a stock pops like Yelp, LinkedIn or even Groupon, it implies that the investment bankers either intentionally underpriced the stock—which means they hustled the owners of the companies that were their clients—or just messed up and mispriced the stock.

When LinkedIn rose to more than twice its IPO price on its first day of trading, I seriously suspected fraud. It was just too extreme to be a simple accident.

But a year later, I now suspect that it’s really a matter of ignorance.

The investment banks just aren’t very good at figuring out how to value these “social media” companies. They surely don’t mean to build in these crazy valuations time and time again; they definitely didn’t mean to bungle Zynga so badly. And the mixed post-IPO performance of the stocks implies a widespread confusion about what these companies are worth.

But ignorance is no defense. The Wall Street guys charge millions in fees, in part justified by their supposed expertise in getting stuff like the price of financial assets right. If Wall Street is nothing more than a gatekeeper to institutional funds, something has gone wrong.

One Big Problem for Tech

Photo by Jodi Gralnick for CNBC.com

Facebook IPO Coffee cup

One problem for tech companies when it comes to dealing with Wall Street is that tech companies aren’t very good customers of Wall Street. A company that can be expected to raise new capital through secondary public issuances or issue debt financing has pull with Wall Street. If you are going to do large acquisitions, especially of other public companies, you can keep bankers loyal to you.

But these tech companies don’t pile on debt, aren’t that active in the public M&A markets, and don’t do big secondary issuances. So the IPO is almost a one-time shot for Wall Street, which makes it tempting for investment bankers to choose valuations that favor buyers in the IPO over the owners of the companies going public.

Facebook certainly has a problem with generating loyalty on Wall Street. Its biggest acquisition to date—$1 billion for Instagram—was made privately between Facebook CEO Mark Zuckerberg and his counterparts at Instagram. So no “advisory” fees for Wall Street.

Facebook won’t be issuing bonds soon. It generates enough cash that it won’t need a public-market capital infusion. And Facebook played tough with the IPO fees themselves. If you are a Wall Street firm, you are obviously incentivized to help out your better-paying customers by underpricing the Facebook IPO.

If I’m right about this, it could mean a substantial pop for Facebook following the IPO. But outside investors should be cautious—the initial pop is often followed by a flop. The favored clients make their profits by selling into the exuberance. You would have lost money on Pandora, Yelp or Groupon if you bought at the closing price on the day of the IPO and held it through yesterday. (To be fair, LinkedIn and Jive would have held up very well.)

On the other hand, Facebook has shown an ability to play tough with Wall Street. It pushed down the fees, it played firms against each other, it made them all but beg to play a role. So maybe they’ve played tough on pricing too.

In any case, we’ll find out on IPO day whether Zuckerberg and his board were able to overcome this pattern of Wall Street hustling tech companies.